Abstract
Apart from being a key component in financial option pricing models, estimates of future uncertainty have important implications in a wide range of decision-making processes, including portfolio selection, risk management, the evaluation of real investment options, the conduct of monetary and fiscal policy, and the management of financial guarantees by regulators. The most widely used estimate of future uncertainty is the return variance that is implied by an option's price. This chapter begins with the evaluation showing how the prices of European options, on the same underlying asset and with the same time to maturity, observed across a range of different exercise prices, can be used to determine the market's implied risk-neutral density (RND) function for the price of the underlying asset on the maturity date of the options. The implied RND, while encapsulating the information contained in implied volatilities, helps complete the market's profile of asset price uncertainty. This type of information is valuable to both monetary authorities and market participants. For monetary authorities, it provides a new way of gauging market sentiment.
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